More investors shorting Chinese yuan

Crisis theorists and others believe China’s currency is set to fall

By

HuoKan

ZhangTao

BEIJING (Caixin Online) — Plenty of smart money is betting on the rise of the yuan, but some overseas foreign-exchange investors are looking the other way.

Contrarians range from hedge funds to wealth-management firms, and they generally agree that the possibility of yuan devaluation against the U.S. dollar is at least slightly greater than market consensus. Chinese policy makers, meanwhile, are not rushing to argue the point.

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Thompson is joined by Mark Hart, investment chief at the Texas-based hedge fund Corriente Advisors, which launched its China Opportunity Master Fund to play against the Chinese currency and economy in general.

Hart said he expects to profit from an economic slowdown in China, telling investors last year that, in his opinion, the Chinese government’s artificial exchange rate controls and low interest rates have created asset bubbles in areas such as real estate and bank credit, and that a downturn will follow.

Mainstream market opinion is still bullish on the yuan, but prices for yuan put options on overseas markets have risen slightly in recent weeks, indicating an increase in yuan-shorting transactions.

Some investor bets against the yuan can be blamed on China’s decision to let the yuan appreciate in recent years through exchange-rate reform, as well as market worries about the health of the Chinese economy.

Since China’s exchange-rate reform began in July 2005, the yuan has appreciated 22% against the U.S. dollar. Meanwhile, China’s overseas trade surplus as a proportion of GDP has decreased from about 7.5% in 2007 to about 3% last year.

A source at State Administration of Foreign Exchange (SAFE), which oversees the currency’s rate, said theoretically there is no basis for a substantial appreciation of the yuan, given China’s recent improvements in current-account and trade balances.

Indeed, the SAFE source said, the yuan may depreciate, since stock and real-estate prices in China are valued significantly higher than international counterparts.

These kinds of official figures and comments are being closely monitored by foreign-exchange players worldwide. Also on radar screens are the Chinese economy’s growth pace, structural adjustment efforts, local-government debt management, the nation’s current-account balance, prospects for capital-account liberalization and inflationary risks.

Indeed, a lot of eyes are fixed on the yuan’s place in the Chinese economy. They’re watching its every move against the dollar.

Foreseeable unforeseen

Thompson thinks the Chinese economy will head downward toward a soft or hard landing. But since the depth of the descent and the landing point can’t be determined, Bienville is “carefully trying to reduce any major leverage risks relying on China’s economic growth rate,” he recently told clients.

A source at an American hedge fund that’s shorting the yuan told Caixin that put options on the yuan in July cost almost twice as much as a year earlier. These options, most of which expire after one year, offer investment companies and hedge funds a way to short the yuan.

The hedge-fund source said rising put prices are a signal that investors are increasingly concerned about volatility in China.

Shorting the yuan these days is a strategy that may be based on crisis theory predictions. One scenario is that the Chinese economy will tank after a bubble pop in the real-estate sector or due to local-government debt defaults. Another crisis possibility is that the Chinese central government will devalue the yuan to stimulate the economy.

A second theory is that market forces, with central bank permission, may drive down the currency’s value. Policy makers may conclude that yuan appreciation has achieved a desired goal.

Hedge-fund activity and put-option prices can point to the extent of foreign shorting of the yuan, said a Hong Kong-based foreign-exchange trader for a European bank.

Another yuan watcher is Broyhill Family Office, a North Carolina-based wealth management company. It’s also shorting the Chinese currency.

Christopher Pavese, Broyhill’s chief investment officer, said June 30 that while no one knows how far the yuan may depreciate, he thinks the possibility is much greater than general market perceptions. Pavese says China’s debt-driven speculative bubble could lead to the devaluation of the yuan becoming a “foreseeable unforeseen.”

“Predicting points in times like this can be challenging and frustrating,” he wrote. “But doubts about timing don’t mean the risks can be ignored.”

Pavese’s take on the yuan turned south after China’s National Audit Commission in June said local-government debt as a proportion of GDP had increased to 27% from 17% three years ago, and that more than 60% of the funds were invested in infrastructure.

Pavese thinks local-government defaults may rise quickly as monetary conditions tighten in a shaky global economy, and a credit slowdown restrains the economy.

“China’s inflation is not just cyclical, and it will constrain policy flexibility,” he said. “In the medium term, credit problems may arise, and their size and severity will exceed any problems that have occurred in the past.”

Thompson said if liquidity access declines in China, which currently benefits from cheap borrowing, the economy will suffer and negatively impact the fragile global economy.

Basic support

Yet the contrarians are telling only one side of the story.

In the eyes of Stephen Jen, a macroeconomic specialist at the London-based hedge fund BlueGold Capital Management, policy makers in China hold the key to the yuan’s exchange rate.

Jen says the rate is more flexible, but government policy is still affecting the pace of change. “The speed of foreign-exchange reserve accumulation is already very fast,” Jen said. “This shows that the magnitude of change in the yuan-to-dollar (ratio) is under the control of policy makers and not investors.”

Investors who think market factors and crisis theory can move the yuan are failing to “understand the special characteristics of Chinese policy,” said Wang Zhihao, director of Greater China research at Standard Chartered Bank. “Even if the economy truly experiences a hard landing, it won’t necessarily mean a devaluation of the yuan.”

A China researcher at a Washington-based hedge fund says China’s central bank is fully able to control the yuan, given its fingers on more than $3 trillion in foreign reserves. If devaluation pressure surfaces, the central bank can make a difference by buying yuan with dollars.

Jen says if the Chinese government decides that fighting inflation is more important than encouraging growth, the yuan will appreciate against the dollar. But a slow appreciation would likely be the government’s response if a substantial slowdown in the global economy in the second half of 2011 weakens confidence in growth.

Additionally, inflation is playing a more important role in yuan exchange-rate adjustments. A U.S. Treasury report on exchange-rate policies in February said the yuan’s appreciation against the dollar is about 10% annually when inflation is taken into account, since China’s inflation rate is significantly higher than America’s.

Adam Kritzer, a foreign-exchange market researcher, sees only a weak economic basis for appreciating the yuan, but that’s not a reason why the currency “won’t or shouldn’t continue to appreciate.”

Yet a variety of technical economic signals are factoring into weaker expectations for yuan appreciation.

For example, China’s foreign-exchange reserves growth slowed in recent months. During the second quarter, only about $152 billion was added, a growth rate that was 22% less than in the first quarter. And in May and June, China’s overseas trade business cooled.

Since May, one-year, non-deliverable forward foreign exchange transactions have pointed to softening expectations for yuan appreciation. For example, forwards compared to China’s same-day, yuan-dollar central parity declined to 1% by July 19 from 3.02% on April 29.

At the same time, domestic yuan deliverable forward and non-deliverable forward prices are inverted. Liu Dongliang, an analyst at China Merchants Bank, said the spread sensitivity for these forward prices indicates expectations of appreciation have weakened. See this report at Caixin Online.

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